Tuesday, 28 May 2013

Investment
banks help companies
and governments and their agencies to raise money by issuing and selling
securities in the primary market. They assist public and private corporations
in raising funds in the capital markets (both equity and debt), as well as in
providing strategic advisory services for mergers, acquisitions and other types
of financial transactions.

·Investment banks
also act as intermediaries in trading for clients. Investment banks differ from
commercial banks, which take deposits and make commercial and retail loans.

In recent years, however, the lines between the two types of structures
have blurred, especially as commercial banks have offered more investment
banking services.

·Investment banks
may also differ from brokerages, which in general assist in the purchase and
sale of stocks, bonds, and mutual funds. However some firms operate as both
brokerages and investment banks; this includes some of the best known financial
services firms in the world.

·In the strictest
definition, investment banking is the raising of funds, both in debt and
equity, and the division handling this in an investment bank is often called
the "Investment Banking Division" (IBD).

·However, only a
few small firms provide only this service. Almost all investment banks are
heavily involved in providing additional financial services for clients, such
as the trading of derivatives, fixed income, foreign exchange, commodity, and
equity securities.

·More commonly used
today to characterize what was traditionally termed "investment
banking" is "sell side." This is trading
securities for cash or securities (i.e., facilitating transactions,
market-making), or the promotion of securities (i.e. underwriting, research,
etc.).

·The "buy
side" constitutes the pension funds, mutual funds, hedge funds,
and the investing public who consume the products and services of the sell-side
in order to maximize their return on investment. Many firms have both buy and
sell side components.

Organizational Structure of an
Investment Bank

·PRIMARY FUNCTION

·The primary
function of an investment bank is buying and selling products both on behalf of
the bank's clients and also for the bank itself. Banks undertake risk through
proprietary trading, done by a special set of traders who do not interface with
clients and through Principal Risk,

·Risk undertaken by
a trader after he or she buys or sells a product to a client and does not hedge
his or her total exposure. Banks seek to maximize profitability for a given
amount of risk on their balance sheet.

·An investment bank
is split into the so-called Front Office, Middle Office and Back
Office.

FRONT OFFICE

·Investment
Banking is the
traditional aspect of investment banks which involves helping customers raise
funds in the Capital Markets and advising on mergers and acquisitions.
Investment bankers prepare idea pitches that they bring to meetings with their
clients, with the expectation that their effort will be rewarded with a mandate
when the client is ready to undertake a transaction.

·Once mandated, an
investment bank is responsible for preparing all materials necessary for the
transaction as well as the execution of the deal, which may involve subscribing
investors to a security issuance, coordinating with bidders, or negotiating
with a merger target.

·SALES AND TRADINGis often the most profitable area of an investment
bank responsible for the majority of revenue of most investment banks.

·In the process of
market making, traders will buy and sell financial products with the goal of
making an incremental amount of money on each trade. Sales is the
term for the investment banks sales force, whose primary job is to call on
institutional and high-net-worth investors to suggest trading ideas (on caveat
emptor basis) and take orders. Sales desks then communicate their clients'
orders to the appropriate trading desks, who can price and execute trades, or
structure new products that fit a specific need.

·RESEARCH is the division which reviews companies and writes reports about their
prospects, often with "buy" or "sell" ratings. While the
research division generates no revenue, its resources are used to assist
traders in trading, the sales force in suggesting ideas to customers, and
investment bankers by covering their clients. In recent years the relationship
between investment banking and research has become highly regulated, reducing
its importance to the investment bank.

·STRUCTURING has been a relatively recent division as derivatives have come into
play, with highly technical and numerate employees working on creating complex
structured products which typically offer much greater margins and returns than
underlying cash securities.

·MIDDLE OFFICE

·Risk
Management involves
analyzing the market and credit risk that traders are taking onto the balance
sheet in conducting their daily trades, and setting limits on the amount of
capital that they are able to trade in order to prevent 'bad' trades having a
detrimental effect to a desk overall.

·Another key Middle
Office role is to ensure that the above mentioned economic risks are captured
accurately (as per agreement of commercial terms with the counterparty)
correctly (as per standardized booking models in the most appropriate systems)
and on time (typically within 30 minutes of trade execution).

·In recent years
the risk of errors has become known as "operational risk" and the
assurance Middle Offices provide now include measures to address this risk.
When this assurance is not in place, market and credit risk analysis can be
unreliable and open to deliberate manipulation.

·BACK OFFICE

·OPERATIONS involves data-checking trades that have been
conducted, ensuring that they are not erroneous, and transacting the required
transfers. While it provides the greatest job security of the divisions within
an investment bank, it is a critical part of the bank that involves managing
the financial information of the bank and ensures efficient capital markets
through the financial reporting function. The staff in these areas are often
highly qualified and need to understand in depth the deals and transactions
that occur across all the divisions of the bank.

·TECHNOLOGY Every major investment bank has considerable amounts of in-house
software, created by the Technology team, who are also responsible for Computer
and Telecommunications-based support. Technology has changed considerably in
the last few years as more sales and trading desks are using electronic trading
platforms. These platforms can serve as auto-executed hedging to complex model
driven algorithms.

Recent Evolution of the Business

·Investment banking
is one of the most global industries and is hence continuously challenged to
respond to new developments and innovation in the global financial markets.
Throughout the history of investment banking, many have theorized that all
investment banking products and services would be commoditized.

·New products with
higher margins are constantly invented and manufactured by bankers in hopes of
winning over clients and developing trading know-how in new markets.

·However, since
these can usually not be patented or copyrighted, they are very often copied
quickly by competing banks, pushing down trading margins.

·For example,
trading bonds and equities for customers is not a commodity business, but
structuring and trading derivatives is highly profitable. Each OTC contract has
to be uniquely structured and could involve complex pay-off and risk profiles.

·Listed option
contracts are traded through major exchanges, such as the CBOE, and are almost
as commoditized as general equity securities.

Possible Conflicts of Interest

·Potential
conflicts of interest may arise between different parts of a bank, creating the
potential for financial movements that could be market manipulation.
Authorities that regulate investment banking require that banks impose a
Chinese wall which prohibits communication between investment banking on one
side and research and equities on the other.

·Many investment
banks also own retail brokerages. Also during the 1990s, some retail brokerages
sold consumers securities which did not meet their stated risk profile.

·This behavior may
have led to investment banking business or even sales of surplus shares during
a public offering to keep public perception of the stock favorable.

·Since investment
banks engage heavily in trading for their own account, there is always the
temptation or possibility that they might engage in some form of front running.

National Role for Investment Banks

·Investment banks
are social institutions. They are custodians and trustees of the public’s money
and promoting national interests—strengthening the sovereignty of our state
technological up-gradation and reduction of asset distributional
inequities—must be explicit objectives of their business strategy.

·These objectives
will not be unintentionally, automatically achieved by profit maximization. A
strategy has to be crafted which deliberately synthesizes financial viability
and profitability concerns with the concern for safeguarding national
sovereignty and promoting national development.

Risk: applies to events for which objective probabilities can be assigned.

Uncertainty: applies to events for which objective probabilities cannot be assigned,
or for which it would not make sense to assign them.

Keynes
(1936):

A game of chance is Risky because, although the
outcome of any one trial is unknown in advance, repetition of the game a large
number of times enables observed relative frequencies to be interpreted
sensibly as objective probabilities.

Uncertain
events are those that cannot be repeated in any
controlled way, thus rendering the calculation of relative frequencies
difficult, if not impossible.

Insurance markets aside, most financial markets
involve uncertainty rather than risk, in the sense that relative
frequencies are not readily available to estimate probabilities.

Most applications in finance permit the
estimation of probabilities from past data or other info.

Financial analysis is located somewhere a long
the spectrum between two polar extremes, one allows for calculating
frequencies while the other doesn’t.

The
Stat-preference Approach (SPA)

v Modelling Uncertainty

The SPA
comprises three basic ingredients:

State of the world, denoted by set S = {s1, s2,..sℓ}. It describes some contingency that could
occur.

Actions, describe all relevant aspects of the
decision that are made before the state of the world is revealed. They
describe choice of assets.

Consequences, express the outcomes of an
action corresponding to each state of the world. They are represented by a
list, each element of which is the total value of the portfolio in
the corresponding state.

If (c) denotes a consequence and (a) denotes an action, then the three components of the theory
are related by a function of (sk)
and (a) such that

c = f(sk, a). Function f(.,.) maps states and
actions into the space of consequences.

In portfolio selection, the function links the
amount of each asset held (the action) to each asset’s payoff in every
state, and hence to the consequence (terminal
wealth).

In the state-preference model, each individual
has a utility function the value of which serves to rank all the possible
consequences.

u = U(f(s1, a), f(s2,
a), …, f(sℓ, a))

The function U(.,.,.,.)
differs across individuals.

The individual’s decision problem is to
maximize utility,
u , by choosing a feasible action
which is a portfolio that satisfies the individual’s wealth constraint,
and other constraints.

At date (0),
today, investors have to make decisions not knowing which of the six
states will occur at date (2).

At date (1),
it becomes known that one of the events has occurred.

Finally at date (2)
the state is revealed.

For simplicity, it is assumed that investors
make decisions with respect to a
single future date.

The payoff on the (n)
assets in the (ℓ) possible state can be
arranged in a payoff array.

Rows correspond to states and columns to
assets.

vkj is the payoff to a unit of asset j if
state k occurs

§Let pj denote the price of
asset (j) observed today. Then the rate of
return on asset (j) in the state (k) is
defined by:

rkj = (vkj - pj) / pj = (vkj / pj) -1

The gross rate of return on asset j, Rkj,
is:

Rkj ≡ (1+rkj)= vkj / pj

Risk-free asset has the same payoff in each state, is denoted with subscript (0),
with payoff (v0) in every state and rate of return:

r0 = (v0/p0) -
1

Suppose there is an asset that has a positive
payoff of one unit of wealth in a particular state, k, and zero in every
other state.

This asset could play the role of an insurance
policy; the purchase of which allows the investor to offset any adverse
consequences in state k, only.

Assume that one such asset exists for every
state.

Investors can insure against the adverse
consequences of every possible contingency.

Conditional on the occurrence of any state,
investors could be certain of obtaining a known payoff, the cost of which
is the asset’s price (or insurance premium).

The presence of such an asset for every state
is sufficient for the existence of a complete set of asset markets.

Otherwise, asset markets are said to be
incomplete

Completeness is an idealization, and useful as
a benchmark against which more realistic circumstances can be evaluated

Decision making under uncertainty

Denote terminal wealth as Wk, the
investor’s utility function is defined over the consequences,

Wk , k = 1, 2, ..., ℓ:

u = U(W1 ,W2 , ..., Wℓ
)

Wk ≡ f(sk, a)

U(.) is similar to standard consumer theory,
but in the presence of uncertainty,
the investor must make a decision before the state is revealed. So, he
must weigh up the consequences across all the conceivable states.The wealth constraint states that the
investor’s outlay on assets equals initial wealth:

p1x1 + p2x2
+ …+ pnxn = A

Where (A) is the initial
wealth and (xj)s denote the number of units of each asset in the portfolio, so that (pjxj) is the amount of wealth devoted to asset j= 1, 2, …n.The portfolio is linked to terminal wealth via
the payoffs of each asset in each state of the world:

Wk = vk1 x1 + vk2
x2 + …+ vkn xn (k = 1, 2, ..., ℓ)

§which is the sum of the payoff of each state multiplied by the chosen
amount of the asset.

The result is a portfolio decision in which the
amount of each asset held depends on asset prices, initial wealth and
preferences.

The analysis can be extended to cover a
multiperiod horizon, generalizing the single period decision problem
described so far.

In this case, preferences (and utility) depend
on the levels of wealth in all states and all dates.

The wealth constraint must be modified to
reflect the opportunities for the investor to transfer wealth from one
period to the next.

The
Expected Utility Hypothesis (EUH)

Assumptions of the EUH

Probability is completely absent from the
analysis in the state preference model.

The EUH approach permits a role for probability
(by assigning probabilities to states of the world) to yield more definite
implications.

By attaching prob. to each state, the EUH
enables a distinction to be drawn between the decision maker’s beliefs (expressed
by probabilities) about which state will occur and preferences about how
the decision maker orders the consequences of different actions

The implications of the EUH emerge by imposing
a number of assumptions:

1.Irrelevance of common consequences. The decision maker orders the actions
independently of the common consequences for states not in the event.

2.Preferences are independent of beliefs. Preferences over consequences for
the given state are independent of the
state in which they occur.

Decision maker cares only about the consequence not the label (e.g. k) of
the state in which it is received.

3.Beliefs are independent of consequences. The decision maker’s degree of
belief about whether a state will occur is independent of the consequences in
the state.

Together,
the three assumptions imply that:

§The decision maker acts as if a probability is assigned to each state.

§There exists a function that is dependent only on the outcomes.

§The decision maker orders the actions according to
the expected value of the utility function.

Formally,
the EUH implies that:

u = U(W1 ,W2 , ..., Wℓ )

= π1 u(W1)
+ π2 u(W2)
+ …+ πℓ u(Wℓ)

where πk is the probability that the investor assigns to state sk.

The u(.) is
the same for all states, although the value of its arguments, wk, generally differs across
states.

But probabilities and u(.)
are allowed to differ across investors.

Assume u/ (W) > 0, meaning that
investors prefer more wealth to less.

The EUH is written as stating that actions are
ordered according to E[u(W)], where E[.] denotes the operation of summing
over the product of probabilities and utilities.

The EUH asserts that actions are chosen to
maximize expected utility:

oE[u(W)] ≡ π1 u(W1)
+ π2 u(W2)
+ …+ πℓ u(Wℓ)

Portfolio Selection In The EUH

The portfolio selection problem can be stated
as: choose the portfolio of assets to maximize expected utility subject to
the wealth constraint.

This is the static problem: it does not address
the issues of (a) revising decisions
overtime, or (b) the possibility that the investor wishes to consume some
wealth before the terminal date.

The analysis is expressed in
terms of rates of return and proportions of initial wealth invested in
assets. Thus, terminal wealth is: W = (1+rP)
A

The
Fundamental Valuation Relationship

Every portfolio that maximizes expected utility
must satisfy a condition called the fundamental valuation relationship
(FVR).

The FVR is the set of first order conditions
for maximizing expected utility, one for each asset.

Its general form is: E[(1+rj)H]=1
j=1,2, …, n

H is a random variable that varies across
states.

If the investor devotes one additional unit of
wealth to asset j.

The payoff is (1+rj)
and the increment to expected utility is E[(1+rj)
u/ (W)].

It means: weight the utility increment in each
state by the state’s probability and sum over the states.

At a maximum of expected utility it is
necessary that the expected utility increment is the same, say λ, for each asset, so that

E[(1+rj) u/ (W)]
= λj=1,2, …, n

If this equation does not hold, then expected
utility can be increased by shifting wealth from those assets with low
values of E[(1+rj) u/ (W)] to those with high
values.

Only
when equality holds for every asset can expected utility be at a
maximum.

λ is the increment to expected utility resulting
from a small increase in initial wealth(i.e. E[u/ (W)]).

At a maximum of
expected utility, the expected marginal utility of wealth must equal the
increment to expected utility from a small change in the holding of any
asset; otherwise, expected utility is not at a maximum.

The 2nd order conditions, together
with the FVR, provide necessary and sufficient conditions that a solution
of the FVR constitutes a maximum of expected utility.

The 2nd order conditions amount to
the requirement that u//(W) < 0; that is, that the investor
is risk-averse.

Risk Neutrality

The case of risk neutrality (u//(W)=0)
implies that the marginal utility of wealth is independent of wealth – say
u/(W) = c, a positive
constant.

This means that:

E[(rj – r0) u/
(W)] = 0

c E[(rj – r0)] =
0

E[rj ] = r0 j=1,2, …, n

The equation involves no choice variable of the
individual, it either holds or it does not.

If it doesn’t hold, the investor can borrow at
r0 and invest an unbounded amount in any asset for which E[rj]> r0;

and short sell an unbounded amount of any asset for
which E[rj]< 0, the proceeds
being invested at the risk-free rate, r0.

This implies that no solution to the
maximization problem unless E[rj
]=r0 holds; (i.e.
the expected return on every asset equals the rate of return on the
risk-free asset).

In such an equilibrium, risk neutral investors
are indifferent about which asset to hold.

It may seem that a world of uncertainty with
risk neutral investors would look rather like a world of certainty (asset
payoffs not differ across states).

But, E[rj
]=r0involves
an expectation.

Exactly one state will be realized, and almost
surely the actual excess return for asset j will be negative or positive
(not zero).

The expectation may be equal to r0
but the actual outcome, when the state is revealed, may will differ. In
this case risk is present (future is unknown) even if investors choose to
ignore it.

The Mean-Variance
Model

The Mean-variance approach
to decision making

The EUH remains a general rule for decision
making unless a specific form is assumed for the von Neumann-Morgenstern
utility function.

One form is that u(.) is quadratic in wealth.
Expected utility can be written as a function of the expected value (mean)
and the variance (or standard deviation) of terminal wealth.

Hence the name “mean-variance analysis” for a
framework that greatly facilitates the construction of optimal portfolios.

Denote the expected value of terminal wealth by
E[W] and its variance by

var[W] ≡ E[(W – E[W])2].

If u(.) is quadratic, the expected value of
u(W) is a function of E[W] and var[W]:

E[u(W)] = F(E[W], var[W])

The
FVR in the Mean-variance model

The
FVR can be written as:

μj – r 0 = μP – r 0 j= 1, 2, …, n (4.15)

σjP / σPσP

Where (σjP) denotes the
covariance between the rate of return on asset j and the rate of return on
the portfolio as a whole.

The ratio (σjP / σP) equals the increment
to risk (as expressed by σP) associated with an incremental change to the proportion of asset j
in the portfolio.

Thus, the FVR states
that each asset’s expected rate of return in excess of the risk-free rate,
μj–r0, per
unit of its contribution to overall risk, σjP / σP, is the same for all assets – a
necessary condition for a mean-variance optimum.

Investor’s preferences
(attitudes to risk) do not appear in expression (4.15).

The equalities depend
only on beliefs (expressed in terms of means, variances and covariances of
assets’ rates of return).

This implies that there
is a role of preferences separate from the role of beliefs.

For a mean-variance
investor, portfolio selection is an outcome of a two-stage process:

. Choose a portfolio
that satisfies the FVR conditions, (4.15). This portfolio takes a very
special form, consisting of only two special assets, which are themselves
portfolios of assets.

o. If a risk-free asset is
available, one of the two special assets can be chosen to comprise just the
risk-free asset alone.

o. Investor preferences are
not relevant in constructing the special assets; their composition depends only
on means, variances and covariances that can be estimated from observed data.

According to investor
preferences, choose the optimal portfolio that optimizes these preferences
(i.e. that reaches the highest feasible indifference curve).

The practical
importance of this approach is that it is often reasonable to assume that
the first stage is the same for all investors who have the same
information, while investors can be allowed to possess their own, unique
preferences (expressing attitudes to risk) in the second stage.